Limiting That Risk

“I spend more time discussing risk and how to limit it than how to achieve investment returns.”

-Howard Marks


At the end of 2010, Howard Marks’ Oaktree Capital Management was running $82.4B in assets under management (Wikipedia). In May of 2011, he published an excellent risk management book titled “The Most Important ThingUncommon Sense for the Thoughtful Investor.” The aforementioned quote comes from the Introduction of his book.


I haven’t finished reviewing his book, but what I can tell you about it so far is that many of Marks’ thoughts will resonate with hardcore Risk Managers. Hope is not a risk management process. Neither is targeting returns. Mr. Macro Market doesn’t owe us anything.


Those who try to simplify investing do their audience a great disservice… successful investing involved thoughtful attention to many areas simultaneously… unfortunately the limitations of language force me to take one topic at a time.” (Marks, Introduction).


At Hedgeye, we call this being:


A)     Multi-factor (Countries, Currencies, Commodities, Companies, etc.)

B)      Multi-duration (TRADE, TREND, and TAIL)


This process, as Marks would undoubtedly support, is “my own approach.” And the only way to prove it out is by executing it out loud, every day, in front of you. “Experience is what you got when you didn’t get what you wanted.” (Marks, Introduction)


Back to the Global Macro Grind


When I can, I like to start the week off with where prices and my positioning ended in the week prior. In the Hedgeye Portfolio (LONGS minus SHORTS) we are still positioned net short (8 LONGS, 9 SHORTS). In the Hedgeye Asset Allocation Model (different risk management product than the LONG/SHORT Portfolio), we maintain very low gross exposure to most things inversely correlated to US Dollars:

  1. Cash = 73% (up from 70% at the start of last week)
  2. Fixed Income = 15% (US Treasury Flattener and Corporate Bonds – FLAT and LQD)
  3. International Currencies = 12% (US Dollar – UUP)
  4. US Equities = 0%
  5. International Equities = 0%
  6. Commodities = 0%

In other words, with markets around the world making new lows, we raised Cash last week – we didn’t “invest” it. That’s what we call limiting proactively predictable risk. From a Risk Factoring perspective, if our model across Countries, Currencies, Commodities, Companies, etc. told us to do otherwise, we would have.


From a Duration Risk perspective, Global Equity and Commodity markets are virtually all broken across all 3 of our core risk management durations (TRADE, TREND, and TAIL). That’s just not good. And we don’t buy things on “valuation” until price, volume, and volatility signals confirm that the valuation we are considering implies numbers that are within the stratosphere of reasonable expectations.


Do the 3 positions we’ve allocated assets to (UUP, FLAT, and LQD) uphold reasonable expectations?

  1. US Dollar (UUP) – Yes. The US Dollar was up a monster +6% for the month of September, outperforming pretty much everything Global Macro by pretty much a country mile (US Treasuries were up +1.5-2% for the month). The USD is now in a Bullish Formation (bullish TRADE, TREND, and TAIL) and what’s bad for Greek storytelling this morning is good for US Dollars.
  2. US Treasury Flattener (FLAT) – Is the Growth Slowing trade still one of the best calls of 2011? Yep. We’ve been long a Flattener since February 2011 as a means of expressing this view and that the Yield Curve would continue to compress as the long-end of the curve chased growth expectations lower. Bernanke’s Twist only perpetuates this compression.
  3. Corporate Bonds (LQD) – American corporate cash balances are cyclically high. Agreed. But, if growth continues to slow, and FX benefits (weak USD) become headwinds (strong USD), they’ll need that cash to buy back stock (Berkshire Hathaway). So… we ladies and gentlemen of Hedgeye would prefer to own corporate bonds than stocks at these prices (unless it’s our own stock).

At a price, will Global Equities be attractive? Obviously yes. But bottoms are processes, not points. And if the most recent month, quarter, and year-to-date in 2011 have anything to say about where to next, the leading of leading indicators (US Stocks) have not started to bottom out yet:

  1. September: SP500 and Russell2000 down -7.2% and -11.4%, respectively.
  2. Q3 2011 (A): SP500 and Russell2000 down -14.3% and -22.1%, respectively.
  3. Year-to-date (2011): SP500 and Russell2000 down -10.0% and -17.8%, respectively.

If anything, the accelerating feature of these prices (on the downside) in the face of accelerating volatility (on the upside) on both the TRADE (3 weeks or less) and TREND (3 months or more) durations only heightens the risk of the US stock market maintaining its already broken long-term TAIL (1266 resistance).


Remember, “the most important thing” about Big Government Intervention in your lives is that it A) shortens economic cycles and B) amplifies market volatility. You definitely want to be focused on Limiting That Risk.


My immediate-term support and resistance ranges for Gold, Oil, Germany’s DAX, and the SP500 are now $1, $77.47-82.19, 5098-5439, and 1113-1157, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Limiting That Risk - Chart of the Day


Limiting That Risk - Virtual Portfolio

The Week Ahead

The Economic Data calendar for the week of the 3rd of October through the 7th is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.


The Week Ahead - 1. lec

The Week Ahead - 2. lec

The Week Ahead - 3. lec

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Apparently, there was a report published by a Macau firm stating that the disruption from Typhoon Nesat which just passed through Macau was so severe that YoY growth in September would only hit 30% or $19.3BN vs. our $20-22BN estimate.  After completing our channel checks, we are fairly confident that Typhoon Nesat had little impact on Macau gaming volumes. While it’s true that for 18 hours there were no ferries to and from HK and Macau, many bridges were closed, and taxis were not running, there were also many people stuck at the casinos with no way of getting home.  Therefore, many of the gaming floors – Wynn, GM, Sands, Venetian, and CoD – were all nicely crowded Wednesday afternoon.  Macau has been used to typhoons and are built to withstand flooding.  This shouldn't be a problem unless another one hits. However, Macau's Meteorological and Geophysical Bureau (SMG) said there may be no more typhoons for this year.  Typhoon Nesat should not have an impact on Golden Week.  


As a reminder, September 29th will mark the close of the month for Macau revenues in September (revenues on the 29th are counted and recorded on the 30th before books are closed).  In order for the numbers to come in at just +30% YoY, table revenues during the last 4 days would have to have shrunk to just HK$144MM/day from a run rate of HK$689MM the week prior and a monthly run rate of HK$686MM.  We think that this is highly unlikely even if hold was terrible.

Not Good: SP500 Levels, Refreshed

POSITION: Short Consumer Staples (XLP)


On every duration that matters in my risk management model, this stock market does not look good: 

  1. TAIL (1266), broken
  2. TREND (1247), broken
  3. TRADE (1181), broken 

And it may be becoming “consensus”…


But consensus can remain right, longer than some can remain solvent.


I do not think this is 2008. I think some refuse to learn the Globally Interconnected lessons of 2008.


This is 2011, and my most immediate-term TRADE line of support is now 1117.



Keith R. McCullough
Chief Executive Officer


Not Good: SP500 Levels, Refreshed - SPX

Shorting Italy (EWI)

Position in Europe: Short Italy (EWI)

Into the close of yesterday’s session Keith shorted Italy via the etf EWI in the Hedgeye Virtual Portfolio.  Italy is a country we’ve come back to numerous times on the short side over the last eighteen months. This time around we got a bounce in the etf to opportunistically trade the security over the immediate term TRADE; however over the intermediate term TREND the country will be hostage to its bond auctions, ECB bond purchasing support, and political instability within the larger context of the country’s and Europe’s sovereign debt and bank contagion crisis.


The country’s outsized debt of 120% of GDP remains a persistent worry, yet pressing is that nearly one-third of its €226 Billion planned bond issuance for 2011 is outstanding. This compares to remaining bond issuance in Germany at 23%, France 17%, Belgium 4%, and Finland 4%, for example, according to Bloomberg.


With the Standard & Poor’s downgrading Italy’s credit rating one notch to A with a negative outlook on 9/19, S&P’s first downgrade of Italy since 2006, demand of  Italian government paper, including the yield it will be priced at, will be increasingly dependent on buying from the ECB under its Securities Market Program [SMP] in the weeks ahead.


We’ve noted in previous work that the 6% yield on 10 year government bonds has been a historically significant level for the PIIGS, meaning that a violation of the line to the upside resulted in an expeditious upward run (see chart below).  Italy, like Spain, has maintained a level below 6% since the ECB restarted the SMP on August 8th, and currently trades at 5.55%.  Last week the SMP bought a total of €3.95 Billion of secondary bonds across the Eurozone (without stating which countries specifically), the smallest amount since the program’s restart that saw €22 Billion in purchases in the first week.


Shorting Italy (EWI) - 1. yie


Investment and political risk remain hot topics in Italy. Investors are still questioning the extent to which Italy’s €54.5 Billion austerity package, which was heavily watered down when it was finally approved last month, will cut enough fat to move the dial on its debt and deficit figures. Much of this indecision is enhanced by the lack of credibility in leadership at the top. And if Berlusconi’s previous scandals weren’t enough to tarnish his reputation, allegedly he has a personal feud with his Economy Minister Guilio Tremonti, perhaps the one man that the market is turning to for a credible answer to the country’s fiscal state.


With the help of our financials team we’ve been able to quantify the exposures of European banks to the PIIGS. As the chart below demonstrates, 4 of the 5 listed Italian banks have over 300% of their Core Tier 1 Capital in PIIGS sovereign debt or commercial loans, with the remaining bank at 287%! While this data is stale, as of the 2010 Stress Test results, it nevertheless paints an ugly picture.


Shorting Italy (EWI) - 1. stein


Italy extended its short-selling ban on Wednesday until November 11th.  The Italian etf EWI is composed of 28.4% Financials, followed by 28.0% Energy, and 21.0% Utilities.


Italy FTSE MIB is down -27% quarter-to-date and over the same period 5YR Italian CDS has risen 300bps to 477bps. As the chart below shows, we don’t see downside support until 12,800, or roughly -13.5% from here.


Shorting Italy (EWI) - 1. ftse mib


Matthew Hedrick

Senior Analyst

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